529 · Taxes

Scenario: Partial Year Resident and 529s

[As with anything tax-related, see my disclaimers.]

We live in Northern Virginia and there are many government employees who frequently move their families to other areas of the country or world on two or three year stints, often cycling back into the area. This can make taxes and finances more complicated.  In this post, I’ll walk through a hypothetical example of a family straddling a partial year residency in Virginia to see what 529s can offer.

Example assumptions:

  • A couple with one college-age child, age 20, attending a university in Utah.
  • The family were residents of Virginia on January 1st of this year but then relocated to Florida on June 1st where the couple will be residents for the remainder of the year. The child is a Utah resident.
  • The total cost of attendance for the 2021-2022 school year is $20,156. This is the maximum that the school expects the student to pay each year.
    • Tuition: $6,120
    • Room and board: $8,048
    • Books and supplies: $912
    • Personal expenses: $2,456
    • Transportation: $2,560
    • Loan fees: $60
  • The child’s is paying all of the college expenses and has the following financial situation:
    • Has earned a half-tuition scholarship worth $3,060
    • Has taken out $3,500 in federally subsidized student loans
    • Is working part-time and expects to make $12,000 for the year, subject to Utah state income tax
    • Actual books, supplies, and fees: $400 (notice it’s less than the expected)
    • Purchased a laptop for $800 to use for school this year
    • Is living off campus with rent + groceries of $500/month for 8 months
    • Gas and transportation expenses: $100/month
    • Round-trip flight home to Florida for Christmas: $400
    • The couple’s income qualifies them for a partial American opportunity tax credit (AOTC) of $1900

Let’s get started!

529 Account: It’s *almost* never too late to start

Ideally, 529 contributions are made when a child is young and the contributions have lots of time to compound. 

While neither the couple or the child have opened a 529 to-date, it’s not too late to save money by opening now. 

Why not? The answer is: state income tax deductions and credits. By contributing to either a Virginia or Utah-sponsored 529 plan, they can save either on Virginia or Utah state income taxes.

Virginia: By living in Virginia for part of the year, the couple can open and contribute to a Virginia 529 plan using income earned in Virginia. The deduction is entered on Schedule ADJ with code 104, and reduces their taxable Virginia income. If they make more than $17k while living in Virginia, they’ll get $57.50 back from every $1,000 put into the account. That’s a 5.75% discount on college-related expenses.

Virginia limits the deduction to $4,000 per account/year, with the ability to roll excess contributions into future tax years. To go past the $4k limit, just open additional accounts.

I’m not 100% sure about the timing of the contributions and residency. Do the contributions to the Virginia 529 need to  be made before the residency change to Florida to qualify? I suspect not and having Virginia-source income for the year is sufficient, but I’m not a tax lawyer, just a random guy on the internet. Talk to your trusted tax advisor to be sure. Keep in mind that only the account owner is eligible for the deduction. In our scenario, even though the child is footing the bill 100%, it may make sense to funnel it through a Virginia 529 that the parent opened to maximize the deduction.

Florida: Florida has no personal income tax and thus, no state income tax benefit from contributing to a Florida 529 savings plan.

Utah: While Utah offers a tax credit for contributions made to my529 accounts, it only applies to contributions made before the beneficiary turns 19. Sadly, the Utah Tax commission anticipated switching beneficiaries to get around this rule (see the heading to Form 510 on the tax considerations of switching beneficiaries). Yes, Utah hates those of us who arrived late to the 529 game. 

The maximum tax credit in Utah is capped at $102 (if filing single; $204 if married), so you aren’t exactly losing a ton.

What can the 529 be used for?

[YES] Tuition & Fees: 529s can be used for tuition, fees, books, supplies, and equipment required for enrollment by the school. 

[YES] Computer Equipment: It can also cover the purchase of computer equipment, software, and internet access, as long as it’s used primarily by the beneficiary for school.

[YES] Room and Board: If the student is a full-time student, reasonable room and board costs can be paid for using 529 funds. However, it’s capped to the amount the school estimates, in this case $8,048 for two semesters.

It cannot be used for travel or generally other expenses outside of the above expenses.

Scholarships and 529s

You’ll notice our scenario involves a scholarship. Lucky child! Fortunately, the IRS doesn’t punish 529 withdrawals for expenses covered by the scholarship. There won’t be the 10% penalty on earnings, but there will be federal income tax due on the earnings. In Virginia, we wouldn’t need to pay back the deduction, but we would in Utah. This means that even if our student gets a scholarship, we could still get a state tax benefit from contributing, even if we end up paying a little bit of tax on whatever the gains were. Given that our scenario is a late-comer to the 529 scene, there’s not going to be much gain so the tax will be very small, as we’ll see below. 

Withdrawing from the 529

The last step is taking the money out of the 529. The only stipulation is that withdrawals from the 529 must be made in the same year that the expense was incurred. For example, if the child in our example paid tuition on January 1st for the winter semester in 2021, they can withdraw the funds anytime until December 31st. If they can pay the expense out-of-pocket now and wait until the end of the year to withdraw it, they’ll have a whole additional year of compounding. For some, this approach is truly mind-bending and they’d rather withdraw money as the expenses occur, treating the 529 more like a savings account. The added benefit is they avoid the risk of the market tanking between now and the end of the year. Either approach has merit.

Funds can be withdrawn by either directing the 529 to pay the school, or by paying the expenses out of pocket and then reimbursing ourselves. Either way, the state will issue a 1099-Q that reports the distribution. If you choose the out-of-pocket method, you’ll want to keep records to substantiate the expenses should you be audited later.

Looking Forward To The Future

In future tax years, our couple won’t qualify for the Virginia state income tax deduction. But their child will still be incurring college expenses. It may make sense to superfund their child’s 529 plan, getting the tax credit now and then withdrawing it in the future. They’ll be limited by their current Virginia income for the year (can’t contribute beyond that to get maximum deduction now) and need to make sure they don’t run into the gift tax limits ($15,000/year in 2021). Given that the couple wants their child to bear the full costs and family budget constraints in the current year, our couple chooses to only focus on 2021.

Scenario Conclusion

Here’s what our couple does:

  1. Our couple is worried the market will tank this year, so they are super conservative. They open three Virginia529 accounts with their child as beneficiary with the following portfolio’s and contribution amounts:
    1. Stable Value: $4,000, opened by husband
    2. Stable Value: $4,000, opened by wife
    3. FDIC-Insured: $3,245, opened by either husband or wife 
  2. Throughout 2021, the couple lets their child continue to pay the expenses directly (e.g. with loan proceeds, work income, and scholarship money). They keep a shared Google sheet recording all the payments the child makes. The child gives the parent’s read-access to their financial records at the school to verify tuition, books, and supply payments. Total education expenses for 2021: $11,245
    1. Tuition: $6,045 ($2,985 for winter semester, $3,060 for fall)
    2. Room and board: $4,000
    3. Books and supplies: $400
    4. Laptop: $800
  3. In December 2021, the couple withdraws $11,245 from the 529 accounts.
    1. Even though they went super conservative, there’s still some expected gain. Stable Value’s current return could be as high as 1.52% and FDIC-Insured as high as .86%. Depending on when they take it out in December, they could have earnings of ~$153 for the year. They can withdraw this in 2022 and give it to their child to cover education expenses in that year.
    2. The couple could also immediately deposit-then-withdraw the money as expenses are incurred, losing out on any possible gains but reducing their risk. They’d still need to be careful not to exceed the $4k/limit per account.
  4. In April 2021, when they file their taxes:
    1. Federal Taxes (some tricky math ahead)
      1. The December withdrawal is made up of $11,094 of contribution and $151 of gains. 
      2. All of the $11,245 expenses are qualified, but the couple will need to pay tax on the gains portion of the withdrawal that exceeded the total qualified expenses – scholarship and AOTC, or $6,285. In this case, the couple pays tax on the gains portion of $4,960 of the withdrawal, 4960/11245, or 44% of the gain
      3. 44% of the $151 gain is $66. Assuming the couple is in the 22% tax bracket, they’ll be paying $15 of additional federal tax
    2. Virginia Taxes
      1. The couple has $29k of Virginia income on their Virginia tax return (otherwise the following numbers will be smaller)
      2. The couple reports a 529 contribution of $11,245 on the Schedule ADJ, code 104.
      3. Virginia does not tax withdrawal due to scholarship
      4. Their 2021 Virginia state tax is decrease by $647
  5. After the April 2021 tax season, the couple writes a check to their child for $632 (VA state tax savings $647 – $15 of additional federal tax)

The total savings passing college expenses that were going to happen anyways through the 529 accounts: $632 of reduced taxes + ~$153 remaining 529 balance: ~$785 

Not a bad return.

Conclusion

$785 might not be a big deal to this couple. But it could be a big deal to the child who is paying their own way through school. Hopefully my scenario was helpful in illustrating several aspects to consider when funding a 529 late and for a part-year resident leaving a state that has generous 529 options.

Anything else I should consider or that I’m missing? Let me know in the comments.

Hasta luego!

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